Ever wondered how you earn interest on your savings account? Chances are it’s not keeping you up at night, but here’s a simple guide for you to work out your savings potential.
There are three important things used to calculate interest on your cash - the principal, interest rate, and time.
- The Principal
This is essentially the amount you have in savings to gain interest. It is recommended that households keep about two month’s salary as a rainy day fund.
- Interest rate
This is the rate offered by your financial institution, and is the percentage of your principal that will become interest every year.
This is interest paid only on the original amount invested. For example, if you have $5,000 in savings (principal) at a 4 percent rate for 6 years, your interest earned will be: $5,000 x 0.04 x 6 = $1,200. However, this assumes that you spend your interest as soon as you gain it.
This is described as ‘interest on interest’. The more frequently interest is paid and reinvested into an account, the greater the final return. This is called compounding, which means interest is being paid on the interest reinvested. In other words, if you leave your savings untouched, then they will grow much faster. For instance, if you invested $10,000 for one year at a 7 percent p.a. and interest is paid quarterly and reinvested, at the end of the year you’ll have earned $175. That’s because $10,000 x 0.07 x (3 / 12) = $175.
How long you save for is just as important in determining your earnings as your interest rate. For example, keeping your cash in a high rate account for only one year will likely earn you less than if you kept it in a lower interest account for two years.
With RateCity’s savings account calculator, you can pin point your return with even more accuracy. For example, you can calculate the impact of additional deposits, and how frequent they are (such as salaries).
You can also input your income tax bracket to work out how much tax you will be paying on your interest.
So experiment with different scenarios and savings methods to see what kind of difference healthy habits can have on your balance. And when you are done calculating, make numbers into reality by searching online for the best rates on savings accounts.